Not My Guru

William Ehart

A LOT OF INVESTORS have spent a lot of time, hope and energy trying to emulate guru portfolios. I’m no different.

When I read Unconventional Success by Yale University’s chief investment officer, David Swensen, I felt like The Truth was being revealed. Here was the wisdom of the country’s top endowment manager with, at the time of publication, a benchmark-crushing 20-year record of 16.1% a year. This wasn’t an attention-seeking fund manager or TV host, but a man who didn’t need or even want my investment dollars. He presented his book as a public service.

Swensen was not offering beat-the-market schemes. He advised that ordinary investors use low-cost index funds, such as those run by Vanguard Group, to capture the returns of what he called the six core asset classes.

Note that Swensen’s endowment portfolio doesn’t resemble the model he put forth for ordinary investors in Unconventional Success. Swensen argues that, with greater resources and market clout, institutional investors such as himself can beat the indexes with active management and heavy use of alternative investments. Recently, alas, that hasn’t been the case: According to the latest data available, the Yale University endowment trailed the S&P 500 by a large margin from mid-2008 to mid-2018, reports Morningstar.

But what about the portfolio that Swensen suggested for everyday investors in Unconventional Success? Since the book’s publication nearly 15 years ago, variations of the Swensen model have been tracked on various websites. Today, it can be found on Portfolio Visualizer (two variations are preset as “Lazy Portfolios” in the “backtest portfolio” function), MarketWatch, Portfolio Charts and Bogleheads. Swensen’s portfolio relies on three key rules:

  • Shun corporate and asset-backed bonds in favor of a fixed-income allocation that is half U.S. Treasurys (15% of the overall portfolio) and half Treasury Inflation-Protected Securities, often called TIPS (another 15%).
  • Avoid putting more than 50% in any one asset class, including stocks, which are divvied up so that 30% of the portfolio is in a U.S. total market index fund, 15% in developed foreign markets and 5% in emerging markets.
  • Think of real estate investment trusts (REITs) as its own asset class—one distinct from stocks but offering equity-like returns (20% of the portfolio).

The Great Financial Crisis might seem tailor-made to illustrate the benefits of Swensen’s portfolio, with its low-correlated assets. Instead, it’s where the Swensen model disappointed the most. With credit freezing up, REITs got hammered even worse than the overall U.S. stock market. And with deflation fears ascendant, TIPS fell almost as hard as the typical fund comprised mostly of corporate and asset-backed bonds.

To benchmark the Swensen model, I backtested it against a more conventional portfolio. The benchmark I created still uses stock index funds and has the same foreign-stock allocation. But where the Swensen model has 30% U.S. stock market index and 20% REITs, my more conventional portfolio has all 50% in the Vanguard Total Stock Market Index Fund. And instead of 15% in Treasurys and 15% in TIPS, I put 30% in the Vanguard Intermediate-Term Investment Grade Fund. I used the Vanguard Intermediate-Term Treasury Fund in my Swensen model because he didn’t specify a duration in the book.

Treasurys, of course, did their job during the financial crisis, rising as stocks fell. But as a result of the poor performance of TIPS and REITs, the Swensen model lost as much as my conventional alternative from the 2007 peak to the 2009 low. Over the past 15 years, it has also exhibited slightly more volatility—as measured by standard deviation—and downside deviation, based on monthly data from the Portfolio Visualizer site.

I still consider Unconventional Success essential reading for investors who want to make informed asset allocation decisions. Swensen’s discourses on “core” and “non-core” asset classes are highly instructive, even if his outright rejection of asset-backed, investment-grade corporate and high-yield bonds seems overwrought.

Looking at the last 15 years, the Swensen model’s relatively light exposure to foreign stocks looks smart. He had foreign stocks at 20% of the overall portfolio and 29% of the stock portion. Some asset allocators say U.S. investors should own foreign stocks in proportion to their weight in global stock indexes, which today means having almost half your stock portfolio invested abroad. Swensen, however, wasn’t predicting that foreign stocks would lag. In fact, he said the expected returns of U.S. and foreign stocks were identical. Rather, he felt investors needn’t take on more foreign currency risk.

Undoubtedly, there will be market environments where the Swensen model outperforms, and perhaps such a period is upon us. Excesses are evident in the corporate bond market, making it vulnerable to a selloff, and future inflation could surprise on the upside, finally rewarding TIPS investors. REITs, meanwhile, have handily beaten the overall U.S. stock market since the financial crisis.

The lesson here isn’t that David Swensen is or was wrong. So what is the moral of the story? Conventional wisdom isn’t always mistaken and it’s folly to slavishly imitate the master investors. Instead, we need to master our own worst impulses—one of which is to rejigger our portfolios every time the gurus speak.

William Ehart is a journalist in the Washington, D.C., area. Bill’s previous articles for HumbleDollar were China SyndromeBefore the Fall and No A for Effort. In his spare time, he enjoys writing for beginning and intermediate investors on why they should invest and how simple it can be, despite all the financial noise. Follow Bill on Twitter @BillEhart.

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